Oil drops to two-week low on supply

SAN FRANCISCO (MarketWatch) -- Crude futures closed at their lowest level in two weeks Wednesday as a smaller-than-expected decline in last week's U.S. crude supply outweighed Hurricane Emily's disruptions to output in Mexico.

"The EIA numbers were very bearish for crude, with inventories only down by 900,000 barrels despite the shipping delays and shut-in production caused by [Hurricane] Dennis" earlier this month, said James Williams, an economist at WTRG Economics.

Williams said most were expecting a larger draw on crude, and "the relatively small draw on gasoline stocks and the 2.3-million-barrel increase in distillates leaves U.S. inventory in pretty good shape."

Crude oil for August delivery fell 74 cents, or 1.3%, to close at $56.72 a barrel on the New York Mercantile Exchange, its lowest closing level since June 30. Earlier, it had climbed to a high of $58.30.

September crude, which became the lead-month contract at the session's end, slipped 67 cents, or 1.1%, to close at $58.02 a barrel.

August unleaded gas closed up 0.25 cent at $1.676 a gallon and August heating oil closed at $1.5977 a gallon, down 3.24 cents.

Early Wednesday, the Energy Department reported a 900,000-barrel decline in crude inventories for the week ended July 15. It pegged total supplies at 320.1 million.

The American Petroleum Institute posted a 5-million-barrel decline to 316.7 million.

At the same time, motor gasoline supplies fell 1.3 million to 211.3 million, according to the government data, and by 4.1 million to 212.3 million, according to the API.

Distillate stocks, which include heating oil, climbed 2.3 million to 122.7 million, the Energy Department said. Supplies were up 1.3 million to 121.5 million, the API reported.

Overall, "there is still no shortage of supply, and crude stocks are in solid shape to withstand a shortfall in Mexican exports due to Emily," said Tim Evans, a senior analyst at IFR Markets.

But while supplies seem ample, this week's data "may not completely reflect the supply disruption from Dennis and Emily," said Kevin Kerr, an editor for the Global Resources Trader investment letter, a service of MarketWatch, the publisher of this report.

At the same time, "a new cluster of storms is forming and there are likely to be many more behind that" -- prompting sellers to be "very cautious," he said.

Emily brings woes

Indeed, "Mexican production losses are mounting" because of Emily, said Phil Flynn, a senior analyst at Alaron Trading in Chicago.

Emily came ashore on the northeastern coast of Mexico, about 80 miles south of the U.S.-Mexico border, on Wednesday, returning to category three-level strength after earlier weakening to a category one storm.

Mexican state-owned oil producer Petroleos Mexicanos has had to cancel daily production of 3 million barrels since Sunday, 80% of which is exported to the U.S., the Associated Press reported.

"It's is obvious [Emily will] be a damaging storm, but questions remain on just how much damage she'll do to the Mexican oil industry," said Flynn.

All in all, "it may take the market a while yet to understand there will be long term ramifications from the damage done by [Tropical Storm Cindy, [and Hurricanes] Dennis and Emily," he said.

About 87 oil and natural-gas rigs and platforms in the Gulf remained evacuated as of Wednesday because of Emily, according to the latest Minerals Management Service report. That compares to 112 on Tuesday.

Some activity has apparently resumed. The MMS said 5.9% of daily oil output in the region remains shut in, compared with 7.5% on Tuesday. About 6.2% of daily natural-gas output was still shut in, vs. 6.5% the previous day.

Price outlook

For now, crude prices will continue to remain near their record levels, "as markets remain anxious about possible supply disruptions due to hurricane activity," according to Thorsten Fischer, a senior economist at Economy.com.

Prices reached an intraday record high of $61.90 on July 8.

"Even as Emily's path has avoided most oil assets in the Gulf, prompting crude to retreat below the $60-per-barrel mark, more tropical storm activity should be expected," warned Fischer.

Once there are more signs of slowing demand growth, Fischer expects crude prices to "show a more pronounced downward correction."

On Wednesday, a monthly report from the American Petroleum Institute said high prices helped weaken demand for petroleum in the first half of this year. See full story.

Natural gas falls

Meanwhile, natural-gas prices closed lower, taking their cue from the decline in crude.

August natural gas shed 3.6 cents to close at $7.55 per million British thermal units. Prices climbed as high as $7.70 earlier.

Analysts at First Enercast Financial expect Thursday morning's report from the Energy Department to reveal a climb of 66 billion cubic feet in natural-gas inventories for the week ended July 15. IFR pegged the likely climb at between 40 billion and 50 billion.

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